Value Investors - The Pendulum will swing back in favour

A recent blog posting over at Morningstar sniped at Professor Jeremy Seigel of Wisdom Tree, indicating that his firm's stock selection methodology and retention of assets depended on his call that a market bottom had been hit.

The post compared the performance of several Wisdom Tree ETFs to various total market benchmarks, showing relative YTD performance is lagging for Wisdom Tree dividend selection process. While true, it ignores the beating that all value benchmarks have taken since the credit crisis began in the summer of 2007.

As most value investors know, they aren't going to beat the benchmark every year - but it's going to happen often enough to outpace "growth" funds by about 2% annually over the long haul.

What's been unusual about this bear market is that it's the so-called value stocks leading the slump, whereas value stocks almost always outperform in weak markets.

Obviously, in this case, that's because the fact is that so many stocks that are usually labelled as value stocks, due to either low PE ratios, or relatively high dividend yields, have found themselves trashed and tarnished by the credit problems. That's because financial firms (whether retail or investment banks, stockbrokers and insurers), which usually have relatively low PE ratios and relatively high dividend yields - putting them squarely in the value camp - have been the epicenter of the credit and economic problems. Wisdom Tree's dividend selection process obviously weights orients a portfolio towards a value selection.

Comparing other value ETFs against growth ETFs show that this phenomenon isn't restricted to Wisdom Tree selections.

For instance, since just before the credit crisis began (I am using June 1 2007 as the date), the Barclays iShares products tracking growth or value indices show the following divergences:

- For international stocks, the MSCI EAFE (Europe, Australia, Far East)iShares index-tracking products shows that the growth product (EFG) has lost -13.2% of its value, compared to much larger -25.3% loss for the value product (EFV). In that context, Wisdom Tree's International Dividend Top 100 EFT (DOO) loss of -16.6% is pretty good.

- For large cap domestic stocks, the iShares growth product (IVW) has lost just -9.0%, while the value product (IVE) has lost -20.8% of it's value. Again, in that context, the Wisdom Tree Large Cap Domestic ETF (DLN) loss of -19.8% is understandable.

- Finally, for domestic small cap, the iShares growth product (IWO) lost 6.5%, while the value ETF (IWN) lost -17.2%. Here, the Wisdom Tree loss is larger at -23.2%.

Given that growth rarely outperforms value for any stretch of time, I believe that the relative outperformance of value must be just around the corner.

In summary, I'd suggest to all value investors in general, and Wisdom Tree ETF holders in particular, to hang on. Retail investors are notorious for dumping underperforming funds, not long before the corner is turned. Don't be one of those fools.



JW

The Confused Capitalist

Hated: Just about everything!

I took a quick trip over to the StockScouter, which is also a link on my sidebar.

According to the algorithm, there are no stock types liked right now.

Those in the "out of favor" category include VALUE & GROWTH (the only two styles they measure) as well as every stock size, ranging from micro cap to large cap. Virtually every sector is also out of favor, with only Health Care and Consumer Non-Durables managing to make the "Neutral" category.

What's "in favor" in terms of Style, Size or Sector?

Nada, Nil, Nothing, Zero, Zilch ... Yada, yada, yada.

Which, folks, is generally the cue to rummage through the so-called trash, looking for those stock bargains.

Happy hunting!

JW

The Confused Capitalist

Betcha a $Billion or two ... Warren Buffett buys more bank stock

Filings covering the period ending September 30 2007 showed that Berkshire Hathaway added to stakes in three large U.S. banks with increased stakes in Wells Fargo & Co (NYSE:WFC), U.S. Bancorp (NYSE:USB) and Bank of America Corp (NYSE:BAC).

Between then and now, prices in two of those three banks fell by around 10% at one point or another, while stock in US Bancorp was available at around the same price as its lowest price in the quarter ending Spetember 30th.

Given Mr. Buffett's well-known penchant for buying discounted, out-of-favour stocks, do you think his next filing will show he added to those positions with his ~$40 Billion cash hoard?

Betcha a billion or two he did.

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JW

The Confused Capitalist

Sectors Still Look Poised for Outperformance

Back in August, right near the bottom of the mini-plunge, I suggested several sectors whose stocks looked poised for outperformance over the longer term, as well as a couple of groups to avoid.

The groups I liked included some of the bigger banks (although I warned that further declines of 10-20% also looked possible), whose yields were then in the 3.4% to 5.0% range or so.

They also included some of the large engineering firms, who I see as prime beneficiaries of the design and oversight work needed to build out the emerging markets infrastructure, and the work needed to replace the aging infrastructure of the western world.

It also included several emerging markets suggestions, and a later posting suggested that distressed credit buyers would have the opportunity to load up their balance sheets with cheap debt, which could fuel earnings for years to come.

Since those predictions, the S&P 500 has bounced up and then down, and is essentially flat over that period.

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The banks mentioned have generally declined, most by about 10-20%, but with Citigroup getting trashed. On the other hand, some have held up pretty well, considering the magnitude of write-offs announced since then. I still like them, and now most of the yields are now in the 5-7% range, making them even more attractive in the face of what I see as a weak market. Maybe it's just me and Warren Buffett who like the bank stocks at these prices.

Engineering firms still look good as a look term-prospect, but this may be somewhat tempered by the fact that most of those discussed have moved sharply upwards, by 10-50% since then.

The emerging markets suggestions have also moved up, by about 15-20% on average of the group discussed.

Finally, a later August 2007 suggestion of looking at some distressed credit buyers is essentially flat as a group.

I still like all of these groups, and think that current prices are likely to look good several years from now.




JW

The Confused Capitalist

Prospecting for great stock values

How do you find great stock prospects?

Well, it's easy but it requires work. The easiest way to begin with some sort of specified list - typically, this works best if you've defined an area or areas of the market that you prefer to invest in. That way, when you see a "wonderfully" priced stock (i.e. read "cheap"), you'll know it, and be able to act on it. This is one of the keys to outperformance - being able to recognize value.

Let me give you two examples from my own portfolio - two stocks - very cheap stocks - that I found. The first was Xceed Mortgage Corp., a Canadian sub-prime lender.

At the time I bought it, it was growing its earnings at a 40-50% rate annually, and yet the PE of this "undiscovered gem" was only in the nine or ten range. In situations like this, you're apt to get rewarded very quickly ... like I was ...



How did I find this? Well, I went through a list of about 400 Canadian financial stocks, eliminating ones that didn't fit my criteria (small/micro cap stocks, as it's easier to find undiscovered value in that area than anywhere else). I then researched the more promising candidates in detail. Overall, this took the best part of two weekends, but I was paid very handsomely for my efforts.

Another area I focus on is herbal medicine/businesses. Spending the better part of a weekend working through a list, I was able to find another undiscovered beauty that also rewarded me very quickly. This was American Oriental Bioengineering, and I found it at a PE of around nine, with an earnings growth rate of better than 50% annually. I was rewarded very quickly in this case too ...



But you can see how much better I would have done, had I even found this stock one month earlier ...

In each case, I also found a couple of other stocks I invested in at that time as well, but it was very clear to me that these two were easily the best ones of those lots, and I invested pretty substantially in both. It probably would have been pretty clear to just about anyone, as the value wasn't that hard to see - what was harder was having the patience and discipline to weed out the others that weren't as promising.

As one final benefit, while the "other" stocks I concurrently invested in didn't do as well, they still did OK, because they at least offered reasonable value. The best thing was that going through those other stocks gave me great confidence that those two both did offer great value and therefore I wasn't scared to overload my portfolio with them - and enjoy the benefits thereafter.

Finding great stock values - easier than you might think.


JW

The Confused Capitalist

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A tale of two cities (stocks): Value Investing

Perhaps I should subtitle this posting: why it pays to be a so-called Value Investor.

"Value Investing" isn't about trying to find a cheap used cigar, as it has sometimes been put. It's about trying to find a stock that seems economically-priced, relative to it's own earnings/balance sheet/revenue, i.e. its own prospects, and that also seems cheaply priced by the market, relative to competitors and even the broader market.

Companies that perform very well often become stocks that are 'priced for perfection', and hence subject to a fall. Which brings me to today's tale. About three years ago, I talked to several of my friends and colleagues about sub-prime mortgage lender Home Capital Group, on the TSX exchange as "HCG". I just loved the prospects of that stock; growing it's earnings at about 30-40% annually, and a PE ratio of about 15 or so. Great balance sheet, very low defaults - believe me, there wasn't much not to love. I bought a bunch and was quite happy with my gains as they unfolded.

However, I later sold out of the stock - it was still a great company, but it's PE kept expanding faster than it's earnings to the point where it was priced (at one point), at a PE of about 30 or so. In pretty short order, it went from $15 to nearly $40.

Readers here know that I generally don't like stocks with mind-bending PE ratios, and so I sold out my shares. With some of the proceeds I invested into a similar situation, the sub-prime lender, Xceed Mortgage Corporation (XMC). A very nice PE, below 10, similar very high earnings growth rate to HCG; not much not to like. It's gone from $4.50 or so, to recently over $10. And with a modest PE expansion to about 13.

Which brings me to Tuesday's news relating to Home Capital - they warned that earnings growth was slowing, but felt they may be able to make their long-time annual target of 20% EPS growth. And now why I don't like stocks "priced to perfection" - over the past two days, Home Capital has lost 23% of it's value, bringing it's PE down from 23 to 17.

Xceed? Well, the stock "fell in sympathy" as they say, but only by 7%. And the major reason for that is the much more reasonable PE - 13 or so. So the PE fell to just under 12. I'm sure that whatever the situation is as it unfolds for Xceed and Home Capital, and others in the sub-prime lending group, that my investment is better protected in the "value investment".

Value Investing: not just your father's investing!


JW

The Confused Capitalist

Deep Value Scorecard - Part II

This continues on a scorecard from The Contra Guys, half of which was shown over here, yesterday. The premise was, that in order to properly assess "deep value" investments, a good scorecard is needed.

Given The Contra Guys excellent long-term record of very high returns using their contrarian investing techniques (26% return annually over 10 years), it's felt that this particular scorecard offers unusual utility. Anyway, yesterday, the first 12 items were given; today, the remaining eleven are shown:

1. Positive financial condition +1 or +2
2. Amount of time followed +1 to +4
3. Book value +1 to +2
4. Reasonable price/earnings +1
5. Downtrodden industry +1
6. Readable annual report +1
7. Public awareness +1
8. Excellent cash flow +1
9. Our understanding of the business +1
10. Possibility of a takeover +1
11. Intangibles +1
    

The benchmark of these 23 items that's required before The Contra Guys will invest is a minimum score of ten. The higher the better obviously. If you want further explanation, you can buy their book, The Contrarian Investor's 13.

Still, using this scorecard alone in assessing deep value situations isn't going to guarantee success. However, it should improve your chances of success by allowing you to more diligently assess a situation, and also ensuring that you have methodically looked at a number of different areas that can enhance returns.

Perhaps another day, I'll show you another scorecard I've used that's been well "field-tested".


JW

The Confused Capitalist

Value Investing and Loading Up the Truck

I just recently read about Seth Klarman, Portfolio Manager of the $5.4 billion investment partnership The Baupost Group, and noted value investor.

Since inception in 1982, the partnership has returned roughly 20% annually, an excellent long-term record. Like most value investors, Mr. Klarman has the discipline to sit on the sidelines when he can't find good value. He also has the courage to dive aggressively in, when he finds what he perceives to be great value.
Mr Klarman also runs a "focused" fund, meaning that he'll have a lot of concentration in a relatively limited number of stocks. What's he buying these days? What he's buying is into the distressed media sector - Rupert Murdock's News Corp. in particular. At present, Mr. Klarman has an almost unbelievable 55% of the fund's value in the class A and regular stock (NWS and NWS-A).

This is something that I also talk about in my book, which I call the ability to "load up the truck" when a very good investment is available at a discount price, in order to produce market-beating performance. Mr. Klarman isn't the only one to have ever benefited their portfolio's returns by doing the same: superinvestor Warren Buffett once said that he had well over 50% of his portfolio in one undervalued stock, and slept like a baby every night.

Mind you, if you do load up on a single stock like that, you better be very confident that it has minimal downside, and very significant upside. And it's almost always easiest to find this type of situation in so-called "value stocks", which is another of the reasons that I have learned to prefer being a "value investor". Stocks with mind-bending PE ratios often lead to mind-bending hair-pulling events - value stocks let me keep my receding hairline relatively intact.

While I can't speak to the relative value of NWS, I think it's noteworthy that a well-known value investor has taken such a large position.



JW

The Confused Capitalist

Deep Value Investing Situations: Use a Scorecard - Part I

One of the things this site promises is a "value" investing orientation. And one of the things most needed to properly assess deep value" situations is a scorecard. Without a scorecard, it's too easy to get caught up in the pessimism of the investment situation, or to become too euphoric because you think you've found the greatest thing since sliced bread.

What you need is a scorecard - and hopefully one that's been tested as having some utility over time. Over the next few days, I'm going to present one that's been used fabulously by its creators, The Contra Guys, North American deep-value investors, Benj Gallander and Ben Stadelmann. These gents run a very fine newsletter service indeed, with an enviable record has produced a 40% annual return over the past five years, and over 26% over the past ten. As with most deep value situations, trading costs are minimized by relatively long holding periods.

(Note: Since these returns are stated in Canadian dollars, the past five year record would be even higher for those whose investments are denominated in US currency.)

In their book and other places, they have produced an investing scorecard that aids them in deciding whether or not to invest in a deep value situation. Their scorecard consists of twenty-three items, to which ordinal values of between -2 to +4 can be scored for each particular measure. The scorecard will be shown over two postings here, so this only consist of approximately one-half of the measured items:

1. Recent downward share price spiral -1
   
2. Single, double, triple, quadruple price upside +1 to +4
3. Negative margin of safety -1
4. Stock is likely to undergo a share consolidation -1
5. Good or excellent management +1 to +2
6. Management ownership position +1 or +2
   
7. Insider trading -1 to +1
8. Excessive versus equitable executive compensation -1
9. High research and development expenditures +1
10. Favorable demographics +1
11. Excessive, or reasonable debt -2 to +2
12. Dividend payout +1

The rest of The Contra Guys scorecard will be presented later, within the next day or two.

JW

The Confused Capitalist